Podcast: Credit Funds: Operating Side-by-Side Open- and Closed-End Private Fund Structures
In this Ropes & Gray podcast, asset management partner Jason Kolman and counsel Jessica Marlin discuss the reasons for the increase in credit managers offering both open- and closed-end funds on a side-by-side basis. Jason and Jessica also discuss the benefits and challenges of pursuing this strategy, including how to consider allocation of investment opportunities, address conflicts that may arise, and explain these products to investors.
Jessica Marlin: Thanks, Jason. One of the main reasons is to be able to serve as a one-stop shop for clients, who may prefer one structure over the other due to regulatory or internal policy needs, or due to the composition of their portfolios. For instance, many investors still have separate pools of capital available for closed-end versus open-ended products. Certain investors even have restrictions on investing in products that can be classified as “hedge funds”, so they may not be willing or able to invest with a sponsor that only offers open-end products. On the other hand, certain types of investors are required to steer clear of products from which they are unable to redeem, and prefer open-ended funds even if those products have significant liquidity constraints. At the same time, the lines between closed-end and open-ended funds in the credit fund space are much less clear than in the past. It’s now common to see open-ended funds with draw down structures and slow pay or similar mechanisms to accommodate illiquid positions, and closed-end funds with the broad ability to reinvest and NAV-based fees. Given this general convergence, some managers may feel that limiting themselves to a particular type of product is unnecessarily constraining, and that they have the tools and experience to manage credit assets across different structures. Jason, what are some other benefits of offering both closed-end and open-ended funds?
Jason Kolman: A broader suite of products will also lead to a larger sponsor AUM and bigger transaction size, which can result in better pricing or other transaction terms, and also allow managers to more effectively implement special situations, distressed credit or other strategies that depend on obtaining a position of influence or control. Similarly, many credit managers want to have products that either have continuous life or that overlap in investment periods, so as to ensure a base of capital that is consistently available for lending to a variety of borrowers and doesn’t fluctuate over time. Despite these benefits, there are some clear challenges to running open- and closed-end funds with overlapping mandates. Jess, can you discuss some of the differences in terms that give rise to these challenges?
Jessica Marlin: Sure, Jason. Despite the increasing convergence in terms, there are still some core differences that can lead to a divergence in interests. At their core, open-ended funds need to manage redemption requests from their investor base, which means that these funds may be less willing to acquire illiquid positions or receive material non-public information that would constrain their trading ability. Similarly, open-ended funds may face difficulties in acquiring positions of influence, if they need to sell to satisfy redemptions. While as we discussed earlier there are certainly ways for open-ended funds to manage for longer-dated or less liquid positions, these measures can be complicated and complex to implement and manage. Jason, what about closed-end funds?
Jason Kolman: By contrast, closed-end funds typically have a limited pool of capital and a fixed investment period and term, and therefore may be more constrained in providing support to existing investments or otherwise participating in opportunities that arise down the line. For example, prepayments and refinancings can be challenging for closed-end funds to manage, given restrictions on recycling capital or making new investments after a certain stage. Closed-end funds also often have a higher return profile than open-end funds (to compensate investors for having their capital locked up) and more investment restrictions and guidelines than open-ended funds. This is why there are generally more investor negotiation and side letters in the closed-end context, since investors can’t simply redeem if they’re unhappy with the direction of the fund. It’s easy to see how these core differences can lead to the different fund types coming into conflict. Jess, what are some of the ways this happens in practice?
Jessica Marlin: Jason, in practice, operating closed-end and open-ended credit funds side-by-side can provide massive economies of scale for sponsors, but it also poses certain challenges. First, it gives rise to increased complexity in the allocation of investment opportunities, as sponsors will have to manage allocations among accounts with overlapping mandates but different terms and liquidity profiles. While there are certain core principles that can guide this process—for instance, senior debt positions may be more appropriate for open-ended funds with a comparatively lower return profile, while illiquid investments may be more appropriate for closed-end funds that don’t need to manage redemptions—specific allocation decisions may need to be made more subjective and context-dependent than for managers that only run a single type of fund. For example, allocation policies that invest based on either NAV (on the open-ended side) or committed capital (on the closed-end side) would need to be revised to be more flexible to accommodate both types of products. In addition, managers would need to carefully consider how to address issues around ramping portfolios and deployment of capital raised over time. Similarly, expense allocation procedures may need to be reconsidered and made more flexible, as managers that have traditionally managed only one type of fund may need a more complex expense allocation methodology. For instance, in a restructuring scenario where open-ended funds are invested at a more senior level of the capital structure and involved in a workout negotiation, this can present difficult questions over whether closed-end funds holding more junior positions should share in restructuring expenses if they will benefit from these efforts, to avoid a potential “free rider” scenario. Jason, what are some of the other issues fund managers face in running side-by-side closed- and open-ended funds?
Jason Kolman: Another important issue is managing the flow of information to investors. Typically, closed-end fund managers share a significant amount of information with their investor base, since investors generally can’t use this information to buy into or redeem from the fund. Conversely, in the open-end space, sharing portfolio information may raise commercial concerns about replication of portfolios, as well as preferential information concerns that certain investors will have a benefit over others in redemptions or subscriptions. Managers should be aware that sharing information on the closed-end side could provide those investors with preferential information regarding the manager’s open-end products, and managers entering the open-end fund market for the first time should reconsider their information sharing policies and sensitize their employees about these issues. More generally, managers should carefully consider that closed- and open-end funds will have differing liquidity and investment concerns. As a result, more hardwired rules around investing side-by-side or redeeming side-by-side may be problematic. In addition, managers should consider whether actions on the part of one fund could impact another, such as whether redemptions from an open-end fund could impact the valuations of the same or related positions held by closed-end funds. Jess, how can sponsors address these conflicts?
Jessica Marlin: While these issues are certainly challenging as you just described, Jason, to manage them, sponsors typically rely on a combination of policies and procedures as well as appropriate disclosures to investors. With respect to policies and procedures, sponsors will need to balance resource-intensive procedures, that entail good record keeping and back testing but allow for more investment flexibility, against flat rules that are easier to administer but can constrain flexibility that investment teams will frequently seek. Because conflicts are fact-intensive, we generally try to steer clients away from creating strict rules, in favor of more general guidelines that afford the flexibility to evaluate particular situations. However, the approach that’s right for a sponsor will depend heavily on its size, resources, risk tolerance and other specific characteristics. For example, a smaller manager may not have the resources to implement conflict mitigation measures such as an ethical wall or separate investment teams, while prescriptive allocation rules may be difficult for a larger manager with many overlapping accounts with broad investment mandates.
In addition to policies and procedures, you will want to draft thoughtful disclosures for both the PPMs and the ADV Part 2A that disclose the specific conflicts you’ll face, depending on your debt strategies as well as your fund types and terms. As an example, if you have a fund with weekly liquidity that makes some of the same investments as a closed-end fund, you’ll want to consider disclosing the potential impact of redemptions in the open-ended fund on the price of those same investments in the closed-end fund. As a general matter, disclosure will be more effective to the extent it is informed by and reflects your actual experiences and real examples. Because conflict scenarios tend to be complex and fact-intensive, it may be helpful to keep notes over the course of the year and think through potential disclosure updates in real-time, so that you can easily and thoroughly address these issues during your PPM and ADV updates. Jason, aside from disclosures, how should managers be explaining these products to investors?
Jason Kolman: From an investor-facing perspective, it can be challenging for sponsors to communicate the difference between products to prospects, since these differences often nuanced. For instance, it may be difficult to explain why an investor with an extensive closed-end fund side letter shouldn’t get a comparable side letter for an open-end fund, why a closed-end fund has more investment restrictions than an open-end fund, or why the funds are taking different actions with respect to a common position. This can generally be managed by clear communication and messaging, such as developing talking points to make sure the key differences are appropriately communicated.
That’s all we have time for today. Thanks to everyone for listening. For more information, please visit our website at www.ropesgray.com. Stay tuned throughout the coming months for more podcasts on topics of interest related to credit funds. And of course, if we can help you navigate any of these challenges, please don’t hesitate to get in touch. You can also subscribe and listen to this series wherever you regularly listen to podcasts, including on Apple, Google and Spotify. Thank you.